Businesses use financial forecasting to help them anticipate future problems, set budgets and make key decisions regarding external financing. The forecasts often take the form of “pro forma” balance sheets and income statements for future periods. You can choose among various methods to make financial forecasts. The percentage of sales method relies on relationships between sales and other items.

Relationships

Many accounts vary with sales. If you can accurately forecast sales growth, you can exploit these relationships to predict changes to other accounts. You begin by dividing current sales revenue into each related account’s current balance. You then apply the resulting factors to forecast future account balances based upon your sales forecasts. To be effective, you need to limit the use of the percent-of-sales method only to accounts that vary closely with sales.

Correlated Accounts

Current assets -- cash, accounts receivable and inventory -- normally closely correlate to sales revenues. Accounts payable also varies with sales. On the income statement, costs of goods sold tie to sales. Using this correlation, you can forecast taxable income, net income and profit margin. To forecast retained earnings, add the forecast net earnings to current retained earnings. You can predict taxes by applying your normal tax rate to forecast taxable income. You use the dividends-to-sales ratio to predict future payout ratios.

Example

Suppose your balance sheet shows current sales revenues of $1.2 million, which you predict will grow by 25 percent in the coming year to $1.5 million. Your current cash balance is $200,000, of 16.67 percent of sales. To forecast next year’s cash balance, multiply $1.5 million by 16.67 percent to get $250,000. Similarly, with current COGS at $0.9 million, the cost-to-sale ratio is 75 percent. Forecast COGS are thus 75 percent of $1.5 million, or $1.125 million, which, when subtracted from forecast sales of $1.5 million, gives forecast taxable income of $375,000. At the 30 percent tax bracket, this creates $112,500 in taxes and thus $262,000 of net income. If your historic payout ratio is 33.33 percent, then forecast dividends are $87,500, leaving $175,000 to add to retained earnings.

Financing Requirements

To complete your pro forma balance sheet based on the percent-of-sales method, you first carry over at current values the accounts that do not closely tie to sales. You next calculate total assets, liabilities and owner’s equity. You will need external financing if two conditions are true: assets exceed the sum of liabilities and equity, and you are using fixed assets at capacity. You then decide how to procure the necessary funding -- you might issue stock, bonds or short-term debt. You will have to perform addition computations if you predict excess assets but you are not using fixed assets at capacity. When you plug in the predicted additional funding, your pro forma balance sheet is complete.

About the Author

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.